Dragged down by protracted financial strains and high commodity prices, the global economy is projected to slow further in the second half of 2008, with a recovery gaining pace gradually in 2009, IMF First Deputy Managing Director John Lipsky said.

"The global economy is facing its most difficult situation in many years as we grapple with the financial crisis that erupted in August 2007, together with the impact of high commodity prices," said Lipsky in a September 9 address to a conference in Frankfurt, Germany, organized by Die Zeit newspaper.

Recovery in global economic activity should begin to take a hold in 2009 as the adverse terms-of-trade effects of the sharp increase in oil prices during 2008 begin to unwind in 2009 and the U.S. housing sector finds a bottom and begins to turn around.

The recovery, he said, would be supported by continued robust domestic demand in many emerging economies that have benefited from rapid integration with the global economy and have been affected to a much smaller extent by the financial turmoil. Global growth is projected to slow from about 5 percent in 2007 to about 3 percent during 2008, before rebounding to about 4 percent in the fourth quarter of 2009.

Core inflation in advanced economies has remained broadly contained, but Lipsky warned that it has increased markedly in emerging economies. "Looking ahead, we see commodity prices likely to stay at much higher levels than previously in real terms and highly sensitive to views about demand and supply trends," he stated.

Global financial strains

In financial markets, Lipsky said that risks remained elevated more than a year after signs of liquidity pressures first surfaced. Against this background, continued deleveraging in the financial sector is likely to act as a substantial constraint on the strength of the global economic recovery.

"While we see gradual economic recovery, the rebound will not be sufficiently sharp to avoid significant restructuring in the financial sector," he said. "The financial sector will look different than before the crisis."

Balance sheet adjustment in the financial sector had progressed, he said. In both the United States and in Europe, banks have raised substantial amounts of capital while writing down about $500 billion, compared to the IMF's original loss estimates of $560-$685 billion for banks and about $1.1 trillion for the entire global financial system.

Lipsky welcomed the move by the U.S. government to take control of the Fannie Mae and Freddie Mac mortgage groups, saying the two institutions (known as GSEs or government-sponsored enterprises) were central to the U.S. mortgage and housing markets.

"The intervention in the GSEs and the broader support to the mortgage market should stabilize the GSEs' balance sheets and the funding of mortgages near-term. This will underpin the U.S. housing market, the banking system, and the broader economy," Lipsky said. He added that the restructuring of the GSEs remains essential to restore market discipline, minimize fiscal costs, and limit future systemic risks.

However, the environment for raising capital and adjusting balance sheets was becoming much more challenging, Lipsky said. And bank lending standards continue to tighten (or remain tight) across advanced economies, as part of a worrisome feedback loop between slower growth and the reduced willingness of financial institutions to extend credit.

"A major risk, going forward, is one of significant financial deleveraging, weighing on global growth prospects for a prolonged period," Lipsky added.

Sound policy options

Lipsky said he remained confident that governments had sound policy options to effectively address many of the tough problems, but policymakers would need to take the right steps. He stressed that collaborative action such as that of major central banks to relieve stress in short-term funding markets has been key in dealing with the financial crisis, but added that more collaborative effort was needed.

"The financial turmoil has revealed that national financial stability frameworks have failed to keep up with financial market innovation and globalization, at the price of deleterious cross-border spillovers," Lipsky said.

National prudential authorities needed to collaborate and coordinate more across borders in an effort to detect, manage, and resolve financial stress early on, and international bodies such as the Financial Stability Forum, the Bank for International Settlements, and the IMF are playing a crucial role in alleviating tensions between national accountability on the one hand and international spillovers of national actions on the other. "More political will to drive forward coordination and collaboration is essential," he said.

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